EconPol WORKING PAPER

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1 EconPol WORKING PAPER January Vol. 2 Dynamc Scorng of Tax Reforms n he European Unon. Salvador Barros Mahas Dolls Anamara Mafe Andreas Pechl Sara Rscado Janos Varga and Chrsan Wneben

2 headed by EconPol WORKING PAPER A publcaon of EconPol Europe European Nework of Economc and Fscal Polcy Research ISSN Publsher and dsrbuor: fo Insue Poschngersr Munch Germany Telephone: Fax: emal: Abenung@fo.de Edors: Danela Abenung Clemens Fues Reproducon permed only f source s saed and copy s sen o he fo Insue. EconPol Europe:

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4 Dynamc scorng of ax reforms n he European Unon Salvador Barros 2 Mahas Dolls 34 Anamara Mafe 2 Andreas Pechl 345 Sara Rscado 2 Janos Varga 6 and Chrsan Wneben 35 Absrac In hs paper we presen he frs dynamc scorng exercse lnkng a mcrosmulaon and a dynamc general equlbrum model for Europe. We llusrae our novel mehodology analysng hypohecal reforms of he socal nsurance conrbuons sysem n Belgum. Our approach akes no accoun he feedback effecs resulng from adjusmens and behavoral responses n he labor marke and he economy-wde reacon o he ax polcy changes essenal for a comprehensve evaluaon of he reforms. We fnd ha he self-fnancng effec Correspondng Auhor: Salvador Barros European Commsson Jon Research Cenre (JRC) Fscal Polcy Analyss Un c/ Inca Garclaso 3 E-4092 Sevlla salvador.barros@ec.europa.eu hps://ec.europa.eu/jrc/en/person/salvador-barros. We are hankful for he valuable commens of he parcpans of he APPAM Fall Conference 206 he pre-appam conference organsed by he Urban Insue n Washngon DC and he Jahresagung 207 of he Veren für Socalpolk. We are also hankful o he edor Kenneh Couch wo anonymous revewers Douglas Holz-Eakn Salvador Espnosa Ahena Kalyva Savna Prncen Adrana Reu Vgna Ivaskae-Tamosune and Wouer van der Welen for her helpful nsghs. The vews expressed are purely hose of he auhors and may no n any crcumsances be regarded as sang an offcal poson of he European Commsson. 2 European Commsson Jon Research Cenre (JRC) 3 fo Insue 4 cesfo 5 LMU Munch 6 European Commsson Drecorae-General for Economc and Fnancal Affars

5 of a reducon n employers socal nsurance conrbuon s subsanally larger han ha of a comparable reducon n employees socal nsurance conrbuons.. Inroducon Assessng he revenue behavoral and macroeconomc effecs of ax reform proposals before her nroducon provdes mporan nformaon o feed he polcal and publc debae. The neracon beween ax reforms and he nduced changes n he economy are mul-faceed. Hence s necessary o capure no only he reacon of economc agens o he ax reforms (n parcular labor adjusmen effecs) bu also he overall economc effec ncludng n he facor and produc markes. The evaluaon of he ax reform effecs s known as dynamc scorng. 7 In he US dynamc scorng analyses are now well esablshed and legally requred before sgnfcan changes n ax legslaon are mplemened. 8 In conras o he US dynamc scorng has no been appled n he fscal governance framework n he European Unon (EU) so far. Ye such analyss would allow an n-deph evaluaon of dscreonary ax measures and a beer assessmen of he rue fscal polcy sance whch reman mporan ssues n he EU (Bu and Van den Noord 2004). Moreover n a polcy conex where he European Commsson analyses he fscal and srucural reform 7 See Adam and Bozo (2009) for a comprehensve assessmen of he dynamc scorng exercse. 8 In he US dynamc scorng analyses are conduced by he Jon Commee on Taxaon (JCT) and he Congressonal Budge Offce (CBO). The JCT has been responsble for a macroeconomc mpac analyss of changes n ax law snce In addon he CBO has ncorporaed hese macroeconomc feedback effecs no her esmaes of fscal effecs f revenue effecs exceeded $5 bllon n any fscal year. Snce 205 he JCT and he CBO are oblged o provde precse esmaes for oupu and revenue feedback effecs of major ax and mandaory spendng changes (see Alshuler e al Auerbach 2005 Furman 2006 Gravelle Holz-Eakn 205 and Auerbach and Grnberg 207 for more deals). 2

6 polces of every Member Sae provdng recommendaons and monorng her mplemenaon accordng o an annual round of polcy dalogue (he so-called European Semeser) he analyss of how fscal and srucural reforms can affec naonal budges as well as Member Saes economc performance s requred. 9 Accounng for macroeconomc feedback effecs of ax reforms s also crucal for he deermnaon of he cyclcally adjused fscal balance whch plays a key role n he European fscal framework (see n parcular Larch and Turrn 200). In hs paper we develop he frs dynamc scorng framework for modellng and analysng ax and benef reforms for all EU counres. A key feaure of our dynamc scorng approach s o combne EUROMOD he mcrosmulaon model for all European Unon Member Saes wh QUEST he European Commsson s dynamc sochasc general equlbrum (DSGE) model used for he analyss of srucural reforms (ncludng fscal ones). 0 By dong so we are able o precsely model acual ax reforms snce EUROMOD conans all relevan rules of he axbenef sysems n he EU Member Saes and allows for he smulaon of drec axes socal nsurance conrbuons and benefs accordng o acual legslaon and hypohecal reform scenaros. Ths s usually no possble usng aggregaed macroeconomc models alone ha only dfferenae beween capal and labor axes (see e.g. Mankw and Wenzerl 2006 Leeper and Yang 2008 Traband and Uhlg 20 Srulk and Trmborn 202). 9 For example recenly he European Commsson has also sared o collec daa on esmaes of he mpac of dscreonary ax measures relyng on he Member Saes' own assessmen and provdng nformaon a a more dsaggregaed level (see n parcular Barros and Fargnol 200). 0 See Suherland (200) and Suherland and Fgar (203) for a descrpon of he EUROMOD mcrosmulaon model and Rao e al. (2009) for deals on he QUEST III model. 3

7 On he oher hand mcrosmulaon models do no ake no accoun agens' reacons o polcy changes and hence gnore how ax reforms endogenously affec prces and quanes as well as moneary and fscal varables n he economy ha can lead o non-neglgble second-round effecs on ax-revenues. By lnkng QUEST wh EUROMOD hese effecs are also ncluded n he analyss. In order o do so we esmae counry specfc labor supply elasces usng a dscree choce labor supply model (Bargan e al. 204) based on he EUROMOD mcro daa and feed hem no he QUEST model. We llusrae our dynamc scorng approach wh an analyss of wo hypohecal reforms of he Belgan socal nsurance sysem: a reducon of he socal nsurance conrbuons pad by employees and employers respecvely. We provde varous robusness checks n order o assess he sensvy of he macroeconomc effecs of he ax reform o he assumpons of he QUEST model. In addon o he analyss of he macroeconomc and fscal effecs of hese ax reforms we provde nsghs no he dsrbuonal effecs of he reform scenaros under consderaon whch s novel o he prevous dynamc scorng leraure. 2 Our resuls ndcae ha accounng for labor supply responses and he macroeconomc feedback o ax polcy changes s essenal for a comprehensve assessmen of he fscal and dsrbuonal effecs of ax reforms. We fnd only weak self-fnancng effecs for ax reforms We also examne reform proposals made for Ialy s and Poland s ax sysem (see Appendx A). All reform scenaros can be precsely smulaed n EUROMOD and are sraghforward examples of reforms affecng personal ncome axes or socal nsurance conrbuons. 2 Noe ha n a dfferen leraure mcrosmulaon models are combned wh Compuable General Equlbrum (CGE) models (see e.g. Pechl Cockburn e al. 204 or Bourgugnon and Bussolo 203). Whle many of hese mcromacro lnkages are sac here are some approaches ha nroduce dynamcs hrough projecons no he model. However hese models don feaure labor marke dynamcs from opmzng frms as n our analyss usng QUEST. 4

8 lowerng he employees ax burden. Afer 3 (5) years he self-fnancng effec amouns o 6% (3%) measured as he percenage change of labor ax revenues upon he ax shock. The reform generaes responses of wages and employmen of oppose sgn wh an expanson of labor supply leadng o hgher employmen bu lower wages. These couneracng effecs explan why frs-round ax revenue effecs derved from he mcrosmulaon model and second-round effecs reflecng behavoral responses and he macroeconomc rajecores derved from he macroeconomc model QUEST dffer only slghly. In conras we fnd much larger self-fnancng effecs amounng o roughly 49% (50%) afer 3 (5) years resulng from cus n employers socal nsurance conrbuons. In hs case boh wages and employmen evolve posvely because of he expansonary labor demand effec generaed by he ax cu. In erms of dsrbuonal mplcaons we show ha boh reducons n socal nsurance conrbuons have regressve effecs wh ncreasng gans along he ncome dsrbuon. The res of he paper s organzed as follows. Secon 2 presens our modellng choces and descrbes n deal he models used n he dynamc scorng exercse. Secon 3 llusraes our approach for hypohecal ax reforms n Belgum. Secon 4 concludes. 2. Modellng second-round effecs of ax reforms In hs secon we frs descrbe he dfferen models used followed by an overvew of he mehodologcal seps of he dynamc scorng analyss. 2. The mcrosmulaon model EUROMOD EUROMOD s a ax-benef mcrosmulaon model coverng all 28 member saes of he European Unon. The model s a sac ax and benef calculaor ha makes use of represenave mcrodaa from he EU Sascs on Income and Lvng Condons (EU-SILC) 5

9 survey o smulae ndvdual ax lables and socal benef enlemens accordng o he rules n place n each member sae. 3 Sarng from gross ncomes conaned n he mcro daa EUROMOD smulaes mos of he (drec) ax lables and (non-conrbuory) benef enlemens and calculaes household dsposable ncomes. 4 The model s unque n s area as negraes axes socal conrbuons and benefs n a conssen framework hus accounng for neracons beween he ax and benefs sysems whch - n he European case - can have a non-neglgble mpac n erms of ax revenues dsposable ncome dsrbuon and also n erms of work ncenves (see n parcular Barros e al. 206). However EUROMOD s sac and only delvers he frs-round effecs of he smulaons. I does no ake no accoun he behavoral response of ndvduals o a gven polcy change. Long-erm polcy effecs are also no addressed wh hs model. EUROMOD uses he laes avalable EU-SILC daa. However snce he frequency of he releases of he survey daa does no concde wh each of he fscal years ncluded n he model whenever he polcy year does no mach he one of he daase EUROMOD uses 3 We use he laes avalable verson G3.0+ of EUROMOD ogeher wh he daases based on he 202 verson of EU-SILC. For he smulaon of he ax reforms we choose 203 ax-benef rules as he baselne. Ths s he mos recen polcy year ha can be smulaed wh EUROMOD a he me of wrng hs paper. Uprang facors are used o nflae he nonsmulaed ncome componens o 203. The mcro daa nclude nformaon on personal and household characerscs several ypes of ncome (e.g. marke ncome pensons or socal ransfers) ceran expendures (e.g. housng coss or lfe nsurance paymens) and oher varables relaed o lvng condons. The valdy of he smulaed aggregaes s ensured by comparson wh he correspondng macroeconomc esmaes provded by naonal ax auhores or by sascal nsues. Valdaon ables are offered n he EUROMOD counry repors for he EU-28 Member Saes whch can be found a hps:// 4 Noe ha some conrbuory benefs (e.g. pensons as well as unemploymen or dsably benefs) are no smulaed bu aken drecly from he EU-SILC daa gven he lack of ndvdual conrbuon hsores ha would be needed o smulae hem. 6

10 ndex varables o nflae or deflae moneary values o he year of he smulaed ax-benef sysem. These ndex varables are called uprang facors and are usually aken from Eurosa (he European sascs agency) or naonal sascal offces. 5 In he conex of hs analyss uprang facors wll be used for ncludng general equlbrum effecs n EUROMOD. 2.2 The labor supply dscree choce model In order o accoun for behavoral responses a he mcro level we esmae a labor supply model. We follow sandard pracce and n parcular Bargan e al. (204) o esmae a random uly dscree choce model. 6 The random uly framework (McFadden 974) s based on he assumpon ha households maxmze uly and hereby face he sandard consumpon-lesure rade-off. In hs seng agens face a dscree se of alernaves n erms of workng hours. Indvduals can choose o work zero hours par-me (20 hours) fullme (40 hours) or over-me (60 hours) so ha he choce covers boh he exensve and nensve margn. The labor supply dscree choce model provdes us wh parameers ha are fed no he macro model (among hese he elasces of labor supply). Economercally our mehodology enals he specfcaon and esmaon of consumponlesure preferences and he evaluaon of uly a each dscree alernave. 7 Uly consss 5 Examples of uprang facors are consumer prce ndces and evoluon of earnngs and sauory adjusmen rules for ceran benefs. 6 Dscree choce models have her heorecal roos n he Random Uly Model of McFadden (974). They have become ncreasngly popular n he labor supply leraure (see Dagsvk 994 Aaberge e al. 995 van Soes 995 or Hoynes 996 for early conrbuons). 7 In conras o he classcal labor supply model where households choose from a connuous se of workng hours (Hausman 985) s no necessary o mpose angency condons and n prncple he model s very general. In pracce a funconal 7

11 of a deermnsc par whch s a funcon of observable varables and an error erm whch can reflec opmzaon errors of he household measuremen error concernng he explanaory varables or unobserved preference characerscs. For he deermnsc par we specfy a uly funcon ha depends on boh household characerscs (such as age number and age of chldren ec. allowng for heerogeney n preferences) and characerscs of he hours caegory (lesure me dsposable ncome as well as fxed coss of akng up work). Besdes preferences household characerscs also nfluence how gross ncome ranslaes no dsposable ncome as effecve ax raes vary wh household characerscs (such as maral saus age famly composon ec.). For denfcaon we explo he resulng varaon creaed by nonlneares and dsconnues nheren n he ax-benef sysem and how hey reflec on households and ndvduals consumpon. 8 Alhough we nclude some of he household characerscs n he esmaed uly funcons ax-benef rules condon on a rcher varey of household characerscs (for example dealed age of chldren regonal nformaon or homeownershp saus). Hence he daa provde varaon n dsposable ncome (as proxy of consumpon) ha allows denfyng he parameers of he economerc model. The dsposable ncome s calculaed for each dscree hour caegory and each household by aggregang all sources of household ncome addng benefs (famly and socal ransfers) and subracng drec axes (on labor and capal ncome) and socal nsurance conrbuons usng form for he uly funcon has o be explcly specfed. However he choce of funconal form has no major nfluence on he esmaed elasces (see Löffler e al. 204). 8 Ths s he usual source of varaon for models esmaed on cross-seconal daa ha canno rely on varaon over me. 8

12 EUROMOD. 9 Appendx B provdes dealed nformaon on he dscree choce model and s underlyng assumpons. 2.3 The macroeconomc DSGE model QUEST III The macroeconomc model used n hs analyss s an exenson of he European Commsson s New-Keynesan model QUEST (o be precse: verson QUEST III see Rao e al. 2009) o nclude dfferen sklled workers. The QUEST model s he sandard model used by he European Commsson o analyse he mpac of fscal scenaros and srucural reforms n he EU Member Saes (see for nsance Vogel 202 n ' Veld 203 Varga and n ' Veld 204). As a fully forward-lookng DSGE model QUEST can capure he behavoral responses of major macroeconomc varables n an open economy conex gong beyond he drec sac mpac of specfc ax reforms measured by EUROMOD. The labor marke modelled n QUEST s srongly based on mcroeconomc heory and suffcenly general o adap o he dfferen labor marke nsuons of he EU counres. More specfcally he model-verson used for hs exercse s a hree-regon open-economy model calbraed for he counry of neres (Belgum) he (res of) euro area and he res of he world. For each regon he model economy s populaed by households and fnal goods 9 In praccal erms he lnk beween EUROMOD and he labor supply model s mplemened accordng o he followng mehodologcal seps. Frs we esmae he hourly wage rae usng a Heckman selecon model. Nex we calculae gross earnngs for each hypohecal hours choce. For nsance for a sngle (couple) household we oban four (6) dfferen gross labor ncomes (descrbng all possble combnaons of hours ha can be chosen by he wo parners). The key assumpon here s ha he predced hourly wage rae does no depend on he number of hours suppled n he labor marke. Ths s a sandard assumpon n dscree choce labor supply models see e.g. Aaberge e al. (2009) Bargan e al. (204) Blundell e al. (2000) Creedy and Kalb (2005) van Soes (994). Allowng wages o vary across choces would lead o complcaons when esmang he lkelhood funcon whch are beyond he scope of hs paper (see he dscusson n Löffler e al. 204). 9

13 producng frms. There s a moneary and fscal auhory boh followng rule-based sablzaon polces. The domesc and foregn frms produce a connuum of dfferenaed goods under monopolsc compeon. In order o measure he dsrbuonal consequences of polces we nroduce hree skll groups hgh medum and low no he model earnng dfferen wages. 20 Appendx C explans n deal he man blocks of our macro model households frms polces and rade. In our dynamc scorng exercse one of he lnks beween EUROMOD and QUEST s he labor marke. In he followng we descrbe he workngs and man drvng forces of hs marke n QUEST. Alhough he general equlbrum effecs nfluence he numercal resuls snce oupu consumpon capal ulsaon and prces are fully endogenous n he model he paral equlbrum analyss of Fgures and 2 can llusrae he basc wage seng mechansm n he QUEST model. These fgures also hghlgh he role played by ax ncdence afer he dfferen polcy shocks are nroduced n QUEST (secon 3.2). Fgure. Reducon of employer-pad axes Fgure 2. Reducon of employee-pad axes Gross wage L D L S Gross wage L S L D L S W W 0 E E 0 L Dlong W 0 W E 0 E L Dlong L D O L 0 L 0 Labor Labor 20 By usng he ISCED educaon classfcaon we defne he share of populaon wh up o lower secondary educaon (ISCED L 0 L 0-2) as low-sklled wh up o upper secondary non-erary educaon (ISCED 3-4) as medum sklled and he res of he populaon as hgh-sklled. 0

14 Noe: he recangle of OL 0 E 0 W 0 s he pre-reform ax-base whle OL E W s he new ax-base afer he correspondng ax-cu. In he fgures L S denoes labor supply and L D s labor demand. 2 Le us consder wo reforms o llusrae he wage seng mechansm n he labor marke. The frs reduces he ax burden of employers (Fgure ) he second he ax burden of employees (Fgure 2). When employeepad labor axes decrease (Fgure 2) workers are wllng o offer more labor servces a all levels of he gross wage and L S roaes down o he rgh o L S. In hs case he ax-cu has wo opposng effecs on he ax-base: n he new equlbrum gross wages are lower and frms are wllng o hre more labor. The ax-base n Fgure 2 ransforms from he shaded OL 0 E 0 W 0 recangle o he OL E W recangle wh srpes. Due o hese wo opposng effecs he axbase may no even change sgnfcanly n he shor-run and scorng exercses wh or whou endogenous wage and labor response mgh gve smlar resuls n he shor-run. When employer-pad labor axes decrease (Fgure ) frms are wllng o hre more labor servces a all levels of he gross wage and L D roaes up o L D. In he new equlbrum gross wages are hgher and frms are wllng o hre more labor a he new wage rae. As boh wages and employmen rse he ax-cu unambguously ncreases he ax-base (from he shaded OL 0 E 0 W 0 recangle o he OL E W recangle wh srpes). Noce ha hs effec would be compleely mssed n a smple sac scorng framework where wages and employmen are kep exogenous. In he long-run he capal sock wll gradually ncrease o s new seady-sae level whch wll lead o hgher labor demand (e.g. L D-long n Fgure and 2) hgher wages and a larger ax- 2 Equaons C.7 and C.5 n Appendx C respecvely. For smplcy we assume ha all oher varables are consan excep real gross wages and labor and here are no adjusmen coss.

15 base. Consequenly along he ranson pah he dfference beween he sac and dynamc scorng revenue esmaes wll ncrease Mehodologcal framework For our analyss we combne he hree models descrbed n he prevous secons as shown n Fgure 3. The frs sep of our analyss consss n runnng EUROMOD for he acual ax-benef sysem and he reform scenaro for he year of neres usng he household mcro-daa for Belgum. Ths sep provdes us wh he change n he effecve ax burden on labor ncome for employees and employers.e. an aggregae ndcaor of he change n he ax burden resulng from he ax reform mplemened n he mcrosmulaon se-up. Ths ax burden s calculaed as he rao of axes and socal nsurance conrbuons on labor ncome o he oal compensaon of employees and payroll axes (see European Commsson 203). Fgure 3. Mehodologcal seps 22 I s mporan o sress ha he Invarance of Incdence Proposon (IIP) does hold n he model over he medum o longrun: a shf of axaon from employers o employees whch leaves overall labor ax revenues consan or only changes he composon of he ax-wedge bu no s sze does no affec employmen and GDP (Goerke 2000). 2

16 Nex we esmae he dscree choce labor supply model. From hs we oban esmaes for parameers such as he non-parcpaon rae.e. he expeced number of ndvduals offerng zero labor hours and he labor supply elasces.e. he percenage change n labor supply gven a one percenage change n gross wages for Belgum. Afer havng esmaed he labor supply model he change n he ax burden resulng from he ax reform s nroduced n QUEST as polcy shocks and labor marke parameers such as he level of gross wages (obaned from he household mcrodaa) he non-parcpaon raes and labor supply elasces (obaned form he dscree choce labor supply model) each obaned for hree skll levels feed no he calbraon of QUEST. 23 By calbrang he man labor marke parameers n QUEST wh he mcro-economerc esmaes obaned from he labor supply model we ensure conssency beween he labor markes n QUEST and he dscree chose model QUEST s calbraed so ha he model maches he observed emprcal daa from Eurosa n erms of labor producvy nvesmen consumpon o GDP raos he wage share he employmen rae a gven a se of srucural ndcaors descrbng marke frcons n goods and labor markes ax wedges and skll endowmens. Mos of he varables and parameers are aken from avalable sascal or emprcal sources from he leraure. Supplemenary daa assocaed wh he calbraon of he QUEST III model can be found n he onlne verson of Rao e al. (2009) a hp://publcaons.jrc.ec.europa.eu/reposory/handle/jrc In hs paper we focus only on he calbraon of seleced parameers whch are drecly relaed o he labor marke. The remanng parameers are pnned down by he mahemacal relaonshps of he model equlbrum condons.e. all agens are maxmzng her uly gven her budge consrans and he feasbly condons of he economy are me. 24 Appendx D provdes nformaon on he aggregaon ssues ha arse from lnkng he wo models. I compares he worker s opmzaon problem and derves he labor supply elasces n boh models. I s shown ha he labor supply elascy esmaed from he dscree choce model can be conssenly used o calbrae he parameer gudng hs elascy n QUEST. 3

17 The second sep of our analyss consss n runnng QUEST n order o oban he hree years macroeconomc rajecores for he endogenous varables of he model. We are manly neresed n he rajecores for he prce level employmen and gross wages snce hese varables are fed back no he EUROMOD model. In he hrd sep we analyze he fscal and dsrbuonal effecs of he ax reforms by feedng he macroeconomc rajecores obaned n he second sep no EUROMOD. Ths s done by uprang prces and wages for he hree-year perod afer he reform. 25 In addon we smulae he employmen rajecory by adjusng he sample weghs n our household mcro daa. 3. Illusraon: hypohecal socal nsurance conrbuons cus n Belgum In hs secon we focus on wo hypohecal ax reforms n Belgum. The frs reform reduces he socal nsurance conrbuons pad by employees he second hose pad by employers. More precsely we smulae:. a reducon of he socal nsurance conrbuons rae pad by employees from 3.07% o 9.07% (by cung he rae for publc pensons by 3 percenage pons and he one for publc healh nsurance by percenage pon); 25 Recall ha EUROMOD nflaes or deflaes moneary varables usng uprang facors whenever he year of he smulaed ax-benef sysem does no concde wh he reference year of he survey daa. 4

18 . a reducon of he sandard socal nsurance conrbuons 26 rae pad by employers from 25.36% o 7.75% (by cung he rae for publc pensons by 5 percenage pons and he one for publc healh nsurance by 2.6 percenage pons). In boh scenaros he oal sauory ax rae of he socal nsurance conrbuons pad by employees and employers s cu by 30%. We smulae reducons of he same conrbuons pensons and healh conrbuons so ha boh reforms "mrror" each oher and her fscal and dsrbuonal mpac can be drecly compared. 3.. Frs sep: Labor marke characerzaon and polcy shocks We frs calculae he change n he effecve labor ax burden for boh reforms usng EUROMOD whch we nroduce as polcy shocks n QUEST. Furhermore wh he help of he dscree choce model we esmae he labor supply elasces and he expeced volunary unemploymen rae whch wll be used o calbrae QUEST. Polcy shocks We follow European Commsson (203) and defne he average effecve ax rae on labor as he rao beween oal axes pad on labor ncome over oal compensaon. 27 For he 26 These sandard socal nsurance conrbuons nclude conrbuons for pensons healhcare dsables unemploymen famly allowances accdens a work (sandard and specal) work-relaed llness (sandard and asbesos fund) educaonal leave negraon and gudance programs for youh daycare provson and (re)employmen of vulnerable groups. As of 206 he referred conrbuons have been subsued by he "global socal nsurance conrbuon". 27 w More formally he average effecve ax rae on labor s defned as he rao PIT +SIC EE +SIC ER where PIT Gross Wages+SIC s he ER personal ncome ax lably of ndvdual and SIC EE and SIC ER are he socal nsurance conrbuons pad by employees and employers respecvely. w s he rao of wages relave o he oal axable ncome of axpayer and s defned as w = Gross wages Toal Taxable Income. Noe ha hs rao does no change afer he reform because s calculaed only from he 5

19 calculaon of he polcy shock we smulae boh reforms of he Belgan ax-benef sysem usng EUROMOD and compue he dfference beween he pre- and pos-reform effecve ax raes on labor ncome. Ths s done boh for employees and employers for hree skll groups respecvely. In hs way we are able o nroduce he changes n he ax raes smulaed n EUROMOD as polcy shocks n QUEST 28. Noe ha hese changes are so-called "mornng-afer" effecs and do no nclude any behavoral responses neher from workers nor from frms. Table. Tax raes and polcy shocks for he Belgum reforms REFORMS 30% Reducon of he SICee ax 30% Reducon of he SICer ax rae rae Hgh Medum Low Hgh Medum Low Tax raes on labor ncome pad by employees (QUEST) Baselne 33.5% 28.8% 27.% 33.5% 28.8% 27.% mcrosmulaon se-up whou ncludng any ype of behavor effecs. We can furher derve he average effecve ax raes for employees and employers as.w PIT +SIC EE and Gross Wages+SIC ER SIC ER Gross Wages+SIC ER respecvely. 28 Noce ha n QUEST he correspondng ax polcy varables are he sauory ax raes on labor leved on workers and frms. These raes are defned n erms of gross wages. Le ws and ers be he ax raes leved on employees and employers for skll group s respecvely. In QUEST he ax burden s defned as ws Gross Wages and ers Gross Wages (see also Appendx D for a descrpon of he ax ncdence mechansm n QUEST). Then sauory ax raes n QUEST and average effecve ax raes n EUROMOD are relaed as follows. Le wseuromod and erseuromod be he average effecve ax raes of employees and employers for skll group s derved from EUROMOD hen: and I follows ha ers = ws Gross Wages = ( w PIT + SIC EE ) = wseuromod (Gross Wages) ers Gross Wages = SIC ER = erseuromod (Gross Wages + SIC ER ) erseuromod and ws = wseuromod. These are he raes presened n Table. erseuromod erseuromod 6

20 Reform 3.% 26.3% 24.5% 33.5% 28.8% 27.% Shocks (percenage pons) Tax raes on labor ncome pad by employers (QUEST) Baselne 20.3% 25.9% 26.9% 20.3% 25.9% 26.9% Reform 20.3% 25.9% 26.9% 6.6% 20.7% 2.4% Shocks (percenage pons) Table shows ha boh reforms reduce he ax raes and ha he sze of he polcy shock s larger n case of he reducon of employers conrbuons rangng from -3.7 percenage pons for hgh-sklled o -5.5 percenage pons for low-sklled workers. Labor supply elasces and non-parcpacpaon raes Labor supply elasces are esmaed usng he dscree choce labor supply model descrbed n secon 2.2. They are used o calbrae he Frsch elascy n QUEST. 29 The expeced number of volunary unemployed s also obaned from he dscree choce model based on he esmaed probably of supplyng zero hours n he labor marke. 30 The elasces as well as he non-parcpaon rae calculaed for hree skll caegores are shown n Table 2. In lne wh he leraure we fnd ha labor-supply elasces as well as non-parcpaon raes are hghes for he low-sklled (see e.g. Bargan e al. 204). Table 2. Calbraon of labor supply elascy parameer and nonparcpaon raes by skll level n QUEST Labor supply elasces Non parcpaon raes 29 Explaned n deal n Appendx C equaons C.23 o C See equaon (C.22) derved n Appendx C. 7

21 Hgh Medum Low Hgh Medum Low Second sep: The macroeconomc mpac We have calbraed QUEST for he Belgan economy he res of he euro area and he res of he world. As explaned n he prevous secon we have se he parameers represenng he Frsch elascy and he non-parcpaon rae based on he elasces and predced labor supply responses obaned from he dscree choce mcroeconomerc model. In he nex sep he changes n he average effecve ax raes on labor pad by employees and employers are nroduced as permanen polcy shocks n QUEST. Imporanly we emporarly se off he deb-sablzaon rule 3 for he frs ffeen years n order o analyze he drec budgeary effec of he reforms. By dong so we are generang a governmen budge defc whch s only closed hrough adjusmens of labor ax raes afer ffeen years. Noe ha dfferen ways o ackle he governmen defc generaed by he reforms may have dfferen second-round effecs and ha our resuls have o be nerpreed n he lgh of hs smplfyng assumpon Equaon (C.2) n Appendx C. 32 In he long-run hese ax-reforms are reversed by an equvalen budgeary change n employee pad labor axes. Alernavely he QUEST model offers a wde range of closure rules whch could be based on he revenue or expendure ems of he governmen's budge consran. Explorng he long-run mplcaons of hese varous alernave fscal closure rules goes beyond he scope of he paper. 8

22 Impulse responses and ax ncdence The nroducon of he shocks for each of he reforms n QUEST orgnaes mpulse responses for he model's endogenous varables showng how he endogenous varables of he model reac o he changes n he ax raes and a he same me how hey evolve ogeher wh he oher endogenous varables. Impulse responses are nformave sheddng lgh on he dynamcs of he model: from he rajecores of he endogenous varables afer a shock we can observe how hese varables evolve smulaneously over me owards he new equlbrum. The mpulse response funcons generaed by he polcy shocks for he man labor marke varables ne real wages 33 oal compensaon of employees 34 gross real wages and employmen are presened n Appendx E (graphs E. o E.8). Noe agan ha he rajecores shown mply he presence of a governmen defc n he economy. The model goes back o he equlbrum only afer ffeen years when he deb sablzaon rule s agan bndng. Graphs E. o E.4 show he mpulse response funcons for he reform of employees conrbuons. In lne wh he smplfed paral equlbrum analyss of Fgure 2 (see secon 2.3) we observe a decrease (an ncrease) n gross wages decrease (employmen) (Graph E.3) because employees are wllng o work more a hgher ne-real wage due o he cu n conrbuons (Graph E.). The oal compensaon of employees (Graph E.2) falls for all skll groups bu n a smooher way because he ax rae pad by employers remans consan n our smulaons and he changes derve only from he smooh decrease (ncrease) n gross wages (employmen). 33 Ne real wages are defned as gross wages mnus axes pad by employees as n expresson (C.42) n Appendx C. 34 Recall ha oal compensaon of employees s defned as he sum of gross wages plus axes pad by employers on labor ncome as n expresson (D.43) n Appendx D. 9

23 Graphs E.5 o E.8 show he mpulse response funcons for he reform of employers conrbuons. As shown n he paral equlbrum analyss of Fgure frms are wllng o offer hgher gross wages o her employees due o he reduced ax burden. Employmen ncreases over he smulaon perod (Graph E.8) as well as gross (and ne) wages (Graphs E.5 and E.7). The oal compensaon of employees (Graph E.6.) mmedaely drops for all skll groups afer he ax cu s nroduced hen smoohly recovers over he perod of analyss due o he ncrease n gross wages along he ranson pah. These resuls are also conssen wh he paral equlbrum analyss of ax ncdence. 35 Sensvy analyss We have performed a sensvy analyss n order o check o wha exen our resuls depend on he ype of shocks consdered and on seleced QUEST parameers and varables. More precsely we compare he followng hree alernave scenaros wh he reform of he employers conrbuons: Scenaro : We replcae he polcy shocks of he employers conrbuons reform and smulae an equvalen reform of he employees conrbuons leavng unchanged he baselne socal nsurance conrbuons rae pad by employers. Ths means ha ex-ane whou any behavoral effec he reducon n labor ax revenues resulng from hs reform equals he reducon resulng from he prevous reform of employers conrbuons; Scenaro 2: We consder a new baselne wh half of he Frsch elasces of he orgnal esmaes for each skll group and apply he polcy shocks derved from he employers conrbuons reform; 35 Descrbed analycally n Appendx D. 20

24 % devaon from baselne Scenaro 3: We sar from a new baselne wh half of he nomnal wage and prce adjusmen coss and apply he polcy shocks derved from he employers conrbuons reform. Fgures 4 o 6 below show he mpulse responses for seleced varables labor ax revenues oal gross wages and oal employmen obaned for each of he hree scenaros descrbed above and for he baselne reform of employers conrbuons. Besdes hese four scenaros Fgure 4 also plos he sac revenue esmae scenaro whch reflecs only he mechancal ax cu of he employers socal nsurance conrbuons whou any endogenous wage and employmen response (denoed by "SICer reform no behavor"). Fgure 4. Labor ax revenues mpulse responses (quarerly percenage devaons from baselne) SICer reform (no behavour) SICer reform Scenaro Scenaro 2 Scenaro 3-9 quarers Fgure 4 shows ha as expeced labor ax revenues decrease afer he polcy shock n all reform scenaros. However we observe ha when he he employers socal nsurance conrbuons are cu he decrease n ax revenues ges smaller over he perod of analyss revealng ha hs reform s o some exen self-fnancng. 2

25 % devaons from baselne % devaons from baselne Fgure 5. Toal gross wages mpulse responses (quarerly percenage pon devaons from baselne) Fgure 6. Toal employmen mpulse responses (quarerly percenage pon devaons from baselne) SICer reform Scenaro 3 2 SICer reform Scenaro 3 2 Scenaro 2 Scenaro 3 Scenaro 2 Scenaro quarers -2 quarers Ths self-fnancng effec can be explaned by he rajecores of wages and employmen: from Fgures 5 and 6 above we observe ha when he ax cu affecs frms boh he wage and employmen have ncreasng rajecores. Ths resul s robus wh respec o he labor supply elascy and he wage and prce adjusmen coss: he mpulse responses obaned for scenaros 2 (lower Frsch elascy) and 3 (lower nomnal wage and prce adjusmen coss) follow closely he ones for he employers socal nsurance conrbuon reform. From Fgure 4 we also observe ha n scenaro where exacly he same ax cus assgned before o employers are now graned o employees labor ax revenues decrease seadly over he perod of analyss. Ths resul can be explaned by he wage and employmen rajecores shown n Fgures 5 and 6: when he ax cu affecs employees only he wage and employmen effecs cancel each oher ou. As a consequence we oban only very modes self-fnancng effecs whch are close o he "no-behavor" suaon. Ths resul s n lne wh 22

26 he rajecores obaned for wages and employmen for he reform of employee s socal nsurance conrbuons (see Table 3 below). Feedback effecs Followng he sandard pracce n dynamc scorng exercses we can also quanfy he behavoral feedback effecs of he reforms. Table 3 shows he revenue feedback effec for each scenaro whch s defned as he percenage dfference of he revenue effec produced by he macroeconomc model relave o he sac revenue esmae (see JCT 2005). Ths measure allows us o quanfy he exen o whch he reforms are self-fnancng hrough economc growh (n our conex changes n wages and employmen). We also decompose he revenue feedback effec no he endogenous feedback conrbuon from wages and employmen respecvely. Table 3. Decomposng he revenue feedback effecs of ax reform scenaros (percenage changes relave o sac esmaes) 36 Years 3 ys 5 ys Employee ax-cu BE effec from employmen effec from wages Employer ax-cu BE effec from employmen effec from wages Noe: Posve percenage change ndcaes ha he esmaed revenue loss s less when he macroeconomc effecs are aken no accoun whle negave percenage change ndcaes hgher revenue loss compared o he sac esmae 23

27 The reform mplemened on he workers' sde generaes lower feedback effecs compared o he reducon of frms' ax burden. By he end of he hree year perod he combned effec of wages and employmen accouns for self-fnancng of abou 6.4% of he reducon n oal labor ax revenues n case of he reform of employees' socal nsurance conrbuons. 37 The self-fnancng effec amouns o almos 50% n case of he employers' socal nsurance conrbuon reform. In lne wh he heorecal predcons (see secon 2.3 Fgures and 2) Table 3 llusraes ha our resul s due o he dfferen behavoral effecs of wages under he wo scenaros: decreasng he frms' ax burden (Fgure ) nduces an upward pressure on wages ncreases he ax-base and he correspondng self-fnancng rae s up o 37.8 % afer fve years. On he oher hand cung he ax burden on employees (Fgure 2) has he oppose effec on he ax-base due o he downward pressure on wages and he correspondng self-fnancng rae s down by around 0 percenage pons. Noce ha he feedback effec from employmen s posve n boh cases: hgher employmen ncreases he ax-base and he correspondng selffnancng raes are up by around 23 percenage pons (employee ax-cu) and 3 percenage pons (employer ax-cu) afer fve years respecvely. The magnude of hese feedback effecs s close o he dynamc scorng resuls of Mankw and Wenzerl (2006). These auhors fnd ha n a sandard neoclasscal model up o half of a capal ax cu can be self-fnancng. However hey oban subsanally lower feedback effec 37 Noe ha we fnd smlar self-fnancng effecs for he Ialan and Polsh reforms presened n Appendx A whch have he same couneracng effecs on wages and employmen as he Belgan reform of employees socal nsurance conrbuons. 24

28 from a labor ax cu rangng from 0% o 7% dependng on he labor supply elascy. 38 Oher dynamc scorng sudes ncludng JCT (2005) and Traband and Uhlg (20) repor smlar paerns for labor and capal ax reform scenaros. Noe however ha our smulaed reform of employer socal nsurance conrbuons s dsncly dfferen from he capal ncome ax cus consdered by Mankw and Wenzerl (2006) and ohers. Therefore our resuls are no drecly comparable for he followng wo reasons. Frs and mos mporanly he large feedback effec n Mankw and Wenzerl (2006) s drven by he response of capal accumulaon o he ax capal ncome ax cu whle we consder cus n socal nsurance conrbuons ha have no prmary mpac on capal accumulaon. Second Mankw and Wenzerl (2006) focus on seady sae resuls whle our feedback effecs are lmed o a 5- year adjusmen perod. 39 Macroeconomc rajecores The fnal annualzed macroeconomc mpac of he ax reforms on he varables of neres s summarzed n Table 4 below. The man dfference beween he wo reforms consss n he sgn of he rajecores for wages: whle he cu n he socal nsurance conrbuons pad by workers generaes downward rajecores for wages for all skll-groups he reducon n he 38 In general hey fnd ha ndependen of how labor supply s calbraed "f capal and labor ax raes sar off a he same level cus n capal axes have greaer feedback effecs n he seady sae han cus n labor axes". 39 The seady sae resuls depend on he budgeary rule whch ensures ha he governmen deb s susanable n he longrun. Mankw and Wenzerl (2006) assume ha lump-sum ransfers (or axes) adjus n response o he changes n ax raes whch offers a budge-neural way o analyse he feedback effec whou nfluencng he behavour of economc agens. Alhough he same assumpon could be nroduced n he QUEST model he genune concep of lump-sum ransfers canno easly reconcled wh EUROMOD. Therefore we op for swchng off he fscal rule n he shor o medum-run leadng o a emporary ncrease n deb and do no mpose addonal axes whch could nfluence he agens behavour n he model. In he long-run we use employee pad axes o resore deb-susanably whch reverses boh ax-reforms. 25

29 employers' conrbuons generaes upward ones. Ths mples couneracng behavoral effecs n he conex of he employees reform resulng n small bu non-neglgble dfferences beween he "no behavor" and "behavor" scenaros consdered n he las sep of our analyss whch s presened n he nex secon. Table 4. Macro mpac of he ax reforms (annualzed % devaon from baselne) on he varables of neres based on QUEST smulaons REFORMS 30% Reducon on he SICee ax rae 30% Reducon on he SICer ax rae T+ T+2 T+3 T+ T+2 T+3 Prce level Employmen Low sklled Medum sklled Hgh sklled Gross real wage Low sklled Medum sklled Hgh sklled Toal labor ax revenue Thrd sep: Mcrosmulaon resuls In he hrd sep of our dynamc scorng exercse we npu he mpulse responses for employmen gross real wages and consumer prce ndex generaed by QUEST back no he mcrosmulaon model EUROMOD n order o assess he medum-erm projecons n ax revenues socal nsurance conrbuons and he dsrbuon of dsposable ncomes. In 26

30 addon we smulae a second scenaro n whch he second round effecs.e. he macroeconomc feedback and behavoral response o he ax change are dsregarded. We analyse boh scenaros over he perod o 3 and compare he medum-erm projecons agans he baselne. More precsely we apply he ax sysem of he baselne polcy year 0 o he subsequen hree years and assess he fscal and dsrbuonal effecs of he ax reforms embeddng he second-round effecs by amendng he uprang facors and he weghs n he household mcro-daa accordng o he macroeconomc feedback provded by he QUEST model (Table 4) for prces and wages. 40 The rajecory of employmen s mpued no he mcrodaa drecly hrough adjusmen of he sample weghs. The exac procedure s as follows. Frs we ncorporae he macro mpac of he ax reforms by creang mcro-daases for each year of analyss ( 2 3 ). For each skll group he weghs of he employed are ncreased accordng o he correspondng mpulse response whle he weghs of he unemployed are scaled down keepng he oal populaon consan. In hs way he employmen effec esmaed n QUEST s mplemened as an exensve margn effec n he household mcro-daa. Second he mpulse response for he consumer prce ndex s negraed n EUROMOD as a correcon of he corresponden uprang facor. Fnally for gross wages we apply he same approach as for he consumer prce ndex wh he only excepon of havng uprang facors for each skll caegory. We subsequenly run he mcrosmulaon model o quanfy he overall budgeary and dsrbuonal effecs of he wo reforms under he wo scenaros. These resuls are presened 40 The npu daa fles used here are based on EU-SILC 202 survey daa whch do no correspond wh he baselne year 203 for he smulaon of he ax reforms n EUROMOD. Therefore he uprang facors allow for me conssency beween he moneary varables of he survey and he ax sysem under analyss. 27

31 n deal n Fgures 7-2. Fgures 7 and 8 presen he mpac on he wo affeced subcomponens of employee and employer socal nsurance conrbuons penson and healh nsurance conrbuons whle Fgures 9 o 2 show he mpac on broader caegores of ax revenues (.e. governmen revenue from personal ncome axes and socal nsurance conrbuons) as well as he mpac on household dsposable ncome by ncome decle. Fgure 7. Employee conrbuons mpac n EUROMOD ncorporang macro feedback on prces wages and employmen -395% Employee conrbuon o penson nsurance % Employee conrbuon o healh nsurance % -28% -399% -40% -282% -403% Tax polcy change no behavoural reacon Tax polcy change ncludng behavoural reacon -283% Fgure 7 shows ha employee socal nsurance conrbuons decrease boh n he presence and n he absence of second-round effecs. In and 2 he drop s larger n he scenaro accounng for second-round effecs snce he new equlbrum n he labor marke mples lower gross wages and consequenly lower socal nsurance conrbuons. However we fnd ha he posve employmen effec counerbalances he negave wage effec leadng o a lower ax revenue loss n 3. Penson nsurance conrbuons decrease by around 40% whle healh conrbuons decrease by 28%. 28

32 Fgure 8. Employer conrbuons mpac n EUROMOD ncorporang macro feedback on prces wages and employmen -53% Employer conrbuon o penson nsurance % Employer conrbuon o healh nsurance % -36% -37% -55% -38% -56% -39% -57% Tax polcy change no behavoural reacon Tax polcy change ncludng behavoural reacon -40% Fgure 8 shows ha employer socal nsurance conrbuons declne a dfferen raes dependng on he affeced ax caegory. In he scenaro gnorng behavoral responses he loss n healh (penson) nsurance conrbuons amouns o roughly 40% (57%) n year. In he scenaro accounng for second-round effecs he revenue losses n are margnally smaller (almos percenage pon). The gap gradually wdens over he perod of analyss and reaches 2 percenage pons n year 3. Ths s due o he labor demand expanson ha pushes up wages and employmen. Fgures 9 and 0 show he mpac of he wo ax reforms on broader ax caegores (oal ne ax revenues 4 personal ncome axes and oal socal nsurance conrbuons). 4 By oal ne ax revenues we refer o he governmen revenues derved from smulaed axes and socal nsurance conrbuons ne of means-esed and non means-esed benefs (excludng pensons). 29

33 Fgure 9. Impac of he employee SIC reform on aggregae ax revenues Toal ne ax revenues Personal Income Taxes 0% % 6% -2% 4% -4% 2% Baselne (no polcy change) -6% Tax polcy change no behavoural reacon Tax polcy change ncludng behavoural reacon 0% SIC Employees SIC Employers 0% % -0% 00% % -0% -30% -02% -40% -03% Fgure 9 shows ha he reducon n socal nsurance conrbuons pad by employees leads o a fall n oal ne governmen revenues of almos 3.8% n 3 n boh scenaros. Ths drop s he resul of wo drec "mornng-afer" effecs ha evolve n oppose drecons: on he one hand decreasng employees' socal nsurance conrbuons and on he oher ncreasng revenues from personal ncome axaon (as he axable ncome whch s ne of socal conrbuons broadens). The evoluon of oal ne ax revenues dffers only slghly when we consder second-round effecs: n he frs wo years followng he reform oal ne ax revenues are lower compared o he no-behavor scenaro bu are hgher n year 3. The effec of lower gross wages pushng down oal ax revenues domnaes n and 2 whle he posve employmen effec ouweghs he negave wage effec n year 3. The posve employmen effec also reduces 30

34 unemploymen benef expendure whch conrbues o he sronger ncrease n oal ne governmen revenues n he scenaro ncludng behavoral reacons. As regards he socal nsurance conrbuons pad by employers we observe ha hey shrnk n he frs year bu sar o recover aferwards slghly exceedng he baselne level by he end of he analyzed perod. Ths can be explaned by he smulaneous decrease n gross wages (and corresponden decrease n conrbuons pad) and he ncrease n employmen wh he laer effec beng sronger a he end of he smulaon perod. Fgure 0. Impac of he employer SIC reform on aggregae ax revenues Toal ne ax revenues Personal Income Taxes 0% -2% % -4% 4% -6% -8% 2% -0% -2% Baselne (no polcy change) Tax polcy change no behavoural reacon Tax polcy change ncludng behavoural reacon 0% SIC Employees SIC Employers 50% 40% 0% -5% % -0% 20% -5% 0% -20% -25% 00% % Fgure 0 llusraes ha here s a mmedae revenue loss n amounng o 9.8% n he nonbehavor scenaro. When we accoun for he macro feedback on prces wages and employmen we fnd ha he revenue loss s smaller (7.2%) and shrnks o 3.9% by year 3.e. a reducon of roughly 60% (from 7.2 o 2.9 bllon euros). Ths s due o he posve effec 3

35 on wages and employmen rasng he revenues from personal ncome axes (employees' socal nsurance conrbuon) by 5.2% (4.3%) n 3. In consras o he prevous reform he posve employmen effec s now amplfed by a posve wage effec (wages growh s up o 3.5% for he low-sklled n 3 ). In addon non-means esed benefs declne by 2.3% due o he decrease n unemploymen. Fgures and 2 presen he effec of he reforms on equvalsed dsposable ncome by ncome decles. Fgure. Impac of he employee SIC reform on dsposable ncome (by ncome decle) Fgure shows ha only he frs decle s worse off a he end of he smulaon perod (scenaro ncludng behavoral reacons) wh he negave wage effec offseng he posve "mornng-afer" effec. Overall he reform has a regressve effec wh lower decles 32

36 benefng less han he op of he dsrbuon. The ncrease n dsposable ncome for he boom (op) hree decles s smaller (larger) han % (2%) by year 3. Fgure 2. Impac of he employer SIC reform on dsposable ncome (by ncome decle) Fgure 2 llusraes ha he reform of employers socal nsurance conrbuons rases household dsposable ncome only n he scenaro ncludng behavoral responses wh he excepon of he frs decle. The reform has no no drec frs-order dsrbuve effecs. The rse n dsposable ncome s caused by an expanson n labor demand leadng o hgher wages and employmen. Ths expanson has a regressve mpac wh larges gans for he op decles. In spe of mprovng labor marke condons he frs decle faces a loss n dsposable ncome whch are due o lower benef paymens followng he wage and employmen ncrease. 33